Robust returns mask weakness of city pension system

In the past year New York City's pension funds earned a very impressive 13%, riding the post-election stock market boom, city Comptroller Scott Stringer announced last month. As a result the city will be able to reduce its pension contributions by almost $1 billion for the years 2019 to 2021. This sounds like really good news.

Let's not get carried away. The city's pensions are not in good shape, and any market downturn is likely to put them in a bigger hole—one that could be disastrous during the next decade. Here's the real story, distilled to the three concepts that are key to understanding pensions

The numbers are enormous. The city's five pension funds cover more than 700,000 current workers and retirees and other beneficiaries. They now exceed $180 billion in assets and rank as the fourth-largest pension system in the country. The city must contribute about $10 billion a year—or more than 10% of the entire city budget—to pay for the pensions earned by current workers and the money needed to pay off the funds' debt over a few decades.

The funds have been doing OK lately. The city sets a target for the return it expects on its investments. During the past four years, its average has exceeded its 7% benchmark in large part because of the big gain in the last fiscal year. For the record, the city's increase wasn't that exemplary. The median return of large pension funds around the country for the year ended June 30 was 12.4%.

But any way you figure it, the funds don't have enough money to meet their future obligations. The key metric for a pension fund is whether its assets are enough to pay all future liabilities. A good pension is fully funded at 100%. The state's retirement system is a few percentage points shy of that magic number. The city's is about 65% funded.

The city gets to the 65% number because it assumes it will average a 7% return forever, which is what almost all public pension funds do. However, the best experts say that because the fund is invested in volatile areas like stocks and real estate and private-equity funds, it should assume a much lower average rate of return.

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Don't be fooled by the latest pension returns. The funding picture they paint is not as pretty as it looks.

Warren Buffett, the smartest investor anyone knows, uses a high-grade corporate bond rate, around 4%, as the investment assumption for his Berkshire Hathaway pension fund. In a report earlier this summer, the Manhattan Institute figured out that the city's pensions are only about 47% funded using an average return in line with Buffett's thinking.

When the market plunges, and it will at some point, the state can ride out the decline because it is just about fully funded. The city can't because it is at best two-thirds funded and at worst half funded. If the decline is severe enough, the fund will never recover because it can't earn anything on money it doesn't have. And if a market correction is accompanied by a recession, pension-fund payments will soar just when tax revenues decline.

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